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11/09/2008

Do Depressions Have a Silver Lining? Posner

The costs of a depression in lost output, reduced incomes, and anxiety almost certainly exceed the benefits, and can have disastrous long-run consequences--had it not been for the Great Depression, it is unlikely that Hitler would have become chancellor of Germany. But that is not to deny that there can be some benefits, as our current depression illustrates. (The use of the word "recession" to describe any contraction less severe than the Great Depression is a triumph of euphemism over clarity.)
A depression is an essential backup to efforts to moderate the business cycle. The housing bubble could not expand indefinitely; leverage could not keep growing indefinitely. The government was doing nothing to prick the bubble or to limit leverage. The longer the world economy went without a depression, the worse the collapse would be when it finally, inevitably, came. The saving grace of catastrophes is averting worse catastrophes: imagine if, instead of attacking the United States with commandeered airliners, al Qaeda had waited a few years and attacked with suitcase nuclear bombs. We would not have been on guard, as we are now because of the 9/11 attacks.
A depression increases the efficiency with which both labor and capital inputs are used by business, because it creates an occasion for reducing slack.One might think that a firm that has slack in good times will have as much incentive to reduce it as it would in bad times; slack (failing to maximize profits) is an opportunity cost, which in economics has the same motivational effect as an out-of-pocket expense. But firms are organizations, and organizations experience agency costs, which are more difficult to control in good times than in bad. If a firm's profits are growing, it is easier for the firm's executives to skim some of the profits, pocketing them in the form of excessive compensation or perquisites, than when the firm is shrinking. In the former case, stockholders will be doing well, so the pressure they exert through the board of directors to minimize the extraction of rents by executives and other employees will be less intense than when the firm is at risk of collapse. When the depression ends, the firm will have lower average costs, though they will drift upwards as the firm re-grows.
Government is rife with agency costs as well. The depression will induce states, cities, and the federal government, all of which will be experiencing sharply reduced tax revenues, to provide public services more efficiently. It will accelerate the very desirable trend toward privatization of government services such as toll roads and airports.
By increasing unemployment, a depression increases the demand for education by reducing the opportunity cost of it (forgone income is the largest cost of higher education); and education produces positive externalities. It might seem that the depression would also reduce the income gains from being educated; but those gains accrue over a lifetime and so are little affected by a depression during a person's school years.
A depression is a learning experience. The banking industry has certainly learned a great deal from the current financial crisis about the risks of leverage and the downside of complex financial instruments intended to diversify risk more effectively than by traditional means such as retaining highly safe liquid reserves to buffer any unexpected decline in the bank's loan revenues.
The current depression has depressed commodity prices. Of particular importance has been its dramatic effect on the price of oil, which has fallen by about 40 percent in the last six months. The price spike of last spring seems to have been due primarily to a shortage of supply; the industry could not expand production fast enough to keep pace with surging demand, particularly in China and India. The fall in price seems to have been due primarily to a worldwide reduction in demand for oil caused by the global depression. The combination of low prices with low demand is optimal from the standpoint of U.S. (and probably world) welfare. The low demand reduces the amount of carbon emissions, thus alleviating (though only to a slight extent) the problem of global warming. The fall in the price of oil has reduced the wealth of the oil-producing nations‚Äîa goal that should be central to U.S. foreign policy because of the hostility to us (Russia, Iran, Venezuela), or the political instability (Iraq, Nigeria, Algeria), of so many major oil-producing nations.
By undermining faith in free markets, the depression opens the door to more government intervention in the economy and eventually to higher taxes (though probably not until the economy improves). These are not necessarily bad things. Obviously neither the optimal amount of government intervention nor the optimal level of taxation is zero. There are compelling arguments for greater government intervention to deal with the threat of global warming, to improve transportation and other infrastructure, to reduce traffic congestion, and to protect biodiversity. Though in principle the money needed for such programs could be obtained from cutting wasteful government programs, that is politically infeasible. So taxes will have to rise. Federal taxes as a percentage of Gross Domestic Product are no higher today than they were in the 1940s, 1950s, and 1960s‚Äîperiods of healthy economic growth. The marginal income tax rate reached 94 percent in 1945 and did not decline to 70 percent until 1964 (it is 35 percent today). A modest increase in marginal rates from their present low level would increase tax revenues substantially, probably with little offset due to the distortions that any tax increase is bound to produce.
Taxes should not be increased during a depression, but as we come out of it they can be raised modestly to finance infrastructure investments and other investments in public goods, such as reducing carbon emissions.
The anxiety, reduced consumption, and reduced incomes during a depression are real costs and very heavy ones, but on the other hand the excessive borrowing that precipitated the depression enabled, for a period of years, higher consumption than the nation could actually afford. Thus the current drop in consumption is in part an offset to the abnormal level of consumption earlier. Indeed, since people loaded up with cars, fancy dresses, etc., while times were good (illusorily good because the nation was living beyond its means), the current reduction in the purchase of durables, while hard on sellers, may not be a great hardship to consumers. (Nevertheless, people quickly get habituated to a high level of consumption, and a decline from that level is very painful.)
A related point is that the experience of a depression will induce greater thrift, increasing the formation of investment capital after the depression abates.
Finally, the depression will stimulate fresh thinking by the economics profession. The profession's embarrassing failure to foresee the depression, and the failure of the Federal Reserve Board, of deposit insurance, and of other regulatory institutions and requirements to avert the near collapse of the banking industry, will stimulate fresh thinking about and research in macroeconomics and financial economics; and the regulatory responses initiated by the Bush Administration and those that will be undertaken by the Obama Administration will generate valuable data about the effects of economic regulation. Economists will learn from the bad policies adopted in response to the depression (and some are bound to be bad) as well as from the good ones.

Comments

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Hey Dan,

Do you feel the same way about bailing out General motors? The banks were(are)stupid. General motors was(is)stupid.

What is the middle class anyway?

Cosnstitution? Did not Obama recently say that the Supreme Court should have gotten into the redistribution game as a civil rights issue? Constitution? Takings?

I am not taking sides politically. As far as I am concerned politics IS the problem. The mommy state(democrats) and the daddy state(republicans) are equi-evil and both think that all problems can be solved by political means ie. you vote for me and I will give you some goodies at someone elses expense.

I can't argue with you about the state of national politics. Every now and then I like to go back and re-read Mark Twain's essays for a reality check. I think he gave a St. Patrick's Day speech about 120 years ago where he lamented that St. Patrick was able to drive the snakes out of Ireland but not the U.S. Congress. So the more things change... you know how it goes.

But I'll take you up on defining the middle class, based on standard of living. Able to afford a three or four-bedroom single family home, two cars, and able to afford college tuition for one child at a time at a mid-range private college or university.

What used to be considered "middle class" standard of living now requires a household income of somewhere around $180,000 USD. Based on median income, a two-income household is lucky to be at $90,000 - $100,000. Add in childcare costs.

It isn't about redistributing wealth; it's about redistributing tax burden in a scheme that makes sense. I'll cop to having "socialist" tendencies to the extent that I think the current distribution of wealth in the U.S. is a mockery of the social-mobility model that used to underpin the country. Compare ratio of % of GDP controlled by the top 10% and bottom 10% of the U.S. population to the ratios in other "developed" nations. It is a joke.

Austrian Theory actually predicted the current banking and housing mess. This is a huge accomplishment and a demonstrates that it has a lot more predictive power than rival schools as the Chicago a.k.a. monetarism, and keynesianism.
That's why Krugman and Roubini always check mises.org in search of predictions. But they later claim all the credit, and then propose the keynesian medicine, but remember, they did not use Keynes to come up with the predictions, so their medicine will not work. Why it should?

What's all this talk about taxation problems being the cause of "market failure"? There is a plan already on the shelf tailor made to the problems at hand. Known as the "Land Tax" as developed by the American Henry George in his work, "Poverty and Progress". Any one familiar? Didn't think so. Once again, the "Orthodoxy" has killed off another viable solution. Even "Uncle Milty" recognized it's benefits.

5 billion spent on this last election cycle, 75 to 150 million spent on movies every weekend, endless sold out baseball and football stadia every week, entertainers and sports celebs making millions in pay, universities with billions in endowments, politicians with private gyms, barbershops and restaurants.On and on. A government which takes in 2 trillion per year and is broke, hawked swearing in tickets for thousands. What recession? Let them eat cake. Louis XV is exiting and Louis XVI is taking over.

Apologies in advance for the ensuing rant, but there are themes popping up on this and other economics blogs that I feel need to be addresed:

Progressive taxation is not Socialism. Neither is a negative income tax, unless Friedman was a Socialist (see last week's blog). If you think that progressive taxation is inefficient, give a reason. If you think that a negative income tax is bad for the economy or the country in general, make the argument. The same goes for the bailout. Describing a policy as 'socialism' is not an argument - it is a catch-phrase vulgarized by a desperate political campaign.

Also, the idea that taxation is an unconstitutional 'taking' is absurd. It is specifically allowed by an amendment, once again proving that many who claim to be 'Constitutionalists' have no idea what the actual document says or means. And no, it is not an unconstitutional amendment. Moreover, taking is only unconstitutional if it is not accompanied by just compensation. What would just compensation be for a tax? Refunding the money? That would kind of defeat the purpose. Or maybe it is the return of government services. But how could you measure whether the amount of services an individual receives is 'just'?

Clearly, the Constitution says whatever the Supreme Court says it says. There is nothing wrong with taxing but there is something wrong with taxing and then wasting the money on programs which are unnecessary or unneeded or take away incentives to work either from the taxed or the negatively taxed which taxes beyond a certain point surely do. The taxing, the wasting and the giving, to a certain extent, reflects the current public belief that politicians and their government can nourish the public soul and fulfill every desire. I believe that is irrational and dangerous since failure to do so will lead to chaos.It has become common for presidential candidates to refer to themselves as "Commander in Chief" in a general meaning rather than of the armed forces. Is there really a commander in chief of the country or even of the economy? I don't think so. And if there is, I am going to send my restaurant tabs to that person for reimbursement because occassionally I overeat and am distressed by the charges.

As to the bailouts, the banks, insurance companies and automakers allowed stupid,greedy and shortsighted management to ruin their businesses and to put their employees (the people) at risk. The government now is going to give those same morons billions of borrowed dollars with minimal safeguards. The managers will keep their mansions and golf club memberships and the employees might get to keep their jobs so that they can ask the government to help them pay their mortgages. The government will do it because the politicians know that millions of people out of work will lead to the politicians being unemployed.

As to "takings", confiscation of liquid assets would no doubt start a civil war in this country. What would just compensation possibly be? The only reason that a congressional committee would invite such testimony is that the government realizes that it is flat broke and is casting about looking for money to further their (our) mess.

Daniel, I don't much care what name you put on a political philosophy, but One thing about one man one vote, You get exactly what you deserve.

Daniel: you might try actually reading the link that Jim provided to see that the taking we were discussing was not a tax but a proposed federal confiscation of 401k plan funds in order to prop up the failing Social Security system. I re-read my post and I think I was very clear. I'll stand by my assessment of that proposal as an unconstitutional taking.

And as far as your bizarre assertion that tax structure is unrelated to the socialism --> free market capitalism continuum, you don't know what you're talking about. In E.U. countries, for example, taxation provides the funding for national health care, nominal daycare costs and tuition-free university education. Tax policy has everything to do with a nation's position on socializing certain costs. I don't know anyone who holds otherwise.

I wasn't saying that taxation is unrelated to socialism, obviously the more money a government brings in the more it can purchase and control the factors of production (although we are currently increasing the government's role in the market without increasing taxation). All I was saying was that taxation in and of itself is not socialism, and that wealth redistribution in and of itself is not socialism. It depends on what government uses the money for. And I don't think that moving from a 33 to a 38 or 40 percent tax rate approaches the rate at which socialism becomes inevitable - it is probably necessary to keep our current deficit from further balooning (unless you actually think that Government will significantly reduce spending, in which case you are more naive than me).

The examples Dan cites are clearly moves towards socialism, but you have to go the next step and argue why that is a bad thing (a case which can certainly be made). I wasn't attacking you and Jim directly, but was referring to a growing trend of labeling a particular policy as socialist without going into why it is or is not good policy. That reduces substantive debate and the effectiveness of your position.

Jim provided a smart and informed response to my comment. I only wish that he had made it in the first instance. By the way, I agree with you on the moral hazard issue, but I think that the bailout is a necessary evil. There are ways that Congress and Treasury could have structured the program to minimize the moral hazard issue, but I am certainly not holding out any hope that they will do so - my confidence in our politicians is about as high as yours.

Your statement that "A modest increase in marginal rates from their present low level would increase tax revenues substantially, ....." is wrong and misleads. One lesson I remember from my University of Chicago training several decades ago is that if you tax something at a higher rate you get less of it. In fact recent empirical evidence suggests that reducing tax rates generates tax revenue increases as should be expected if one but considers the behavioral effect on the production of income that the tax rate level inevitably imposes. . I refer you to the Internal Revenue Service who reported in 2004 that the highest 5%, of all individual taxpayers paid $406 billion in federal taxes. 2004 was significant because it was the first full year when the top federal income tax rate was reduced from close to 40% to 35% and a reduction in capital gains tax to 15% applied. So what happened in 2005 the second full year of the lower 35% marginal rate? One might expect this lower rate would produce reduced tax revenues. But just the opposite happened, the 6.6 million tax payers in this prosperous group paid 37% higher taxes as they paid more than $550 billion into the U.S. Treasury. It is noteworthy that this top 5% of income reporters accounted for 60% of revenues collected from individuals. I would be grateful if you or any of your readers can identify any examples of similar scale where income tax rate increases raised revenue to the government.

Vince, As for revenue increases and social benefit via taxation, try 1861 when it was first imposed under, Article 1, Sec. 8 of the Constitution, or the 1890's until it was terminated by the Supreme Court under "Pollock vs. Farmers Loan & Trust" and a major recession occured, and then again in 1913 when Congress and the Nation passed the Sixteenth Amendment.

Remember, the advancement of economics and social benefit is dependent on, the establishment of justice, ensuring domestic tranquility, providing for the common defense, and promoting the general welfare. And it all costs. Irrespective of what the UofC School of Economics claims in the classrom.

I would pay more tax with pleasure if the government actually did those things but it doesn't and in addition it wastes at least 660 billion according to the W. R. Grace Commission in 1984 a website referring to which appears below.

The Commission found that in 1984 the government was wasting 33% of every tax dollar paid. Today that would represent 33% of 2 trillion or 660 billion.

Rather than pay more into that kind of incompetence I will work less and spend less, both of which will certainly reduce federal revenue. In addition I will be looking to get my share of "free" education, health care, food, housing, transportation, legal services, etc.

Jim, And what is the "waste" that that 33 cents on the dollar represents? Administrative costs? Haircuts for Senators? Remodeling the Whitehouse? Providing free school lunches? Providing free text books and pencils? Feeding and clothing the Armed Forces? To me that 33% is just a number with no meaning. For all we know it could have just as well been pulled out of the air. Especially if it came from the likes of the Cato Institute.

Jim, I found the Executive Summary. Rather sobering. It clearly points to the fact the OMB/GAO clearly needs to be strengthend and given a set of good sharp teeth. Not too mention, putting the Government on a Zero Based budgeting scheme instead of the Cost Plus method. Also, it might be a good idea to reformulate the Taxing Method (income vs Land). I've already advanced Henry George's idea.

I'd still like to know what the 2,794 specific instances of savings are. Not just the three or four listed in the Executive Summary.

What is so unjust when the prosperous pay more as their 37% tax payment increase in 2005? Like Posner you choose to dismiss the impact of rates on behavoir even in the face of clear evidence that a lower rate produced much higher revenue. Is it just to tax person A's $1 dollar on income at different rate than person B's $1 dollar of income? If we believe all men are created equal, then why would we discriminate over their level of economic output?

What is so unjust when the prosperous pay more as their 37% tax payment increase in 2005? Like Posner you choose to dismiss the impact of rates on behavoir even in the face of clear evidence that a lower rate produced much higher revenue. Is it just to tax person A's $1 dollar on income at different rate than person B's $1 dollar of income? If we believe all men are created equal, then why would we discriminate over their level of economic output?